Recent developments concerning the completed contract method of accounting.

Recent Developments Concerning the Completed Contract Method of Accounting

The completed contract method of accounting for income for long-term contracts is an exception to the annual accounting concept generally governing income recognition under the federal tax laws. Under this method, all costs properly allocable to a contract are accumulated until the contract is completed and accepted. At that point, the contractor includes the contract price in its gross income and deducts the related costs incurred in completing the contract. (1)

Two distinct advantages generally are associated with the completed contract method:

(1) it provides a precise matching of income and expenses and

(2) it permits the contractor to defer income, and thus taxes, until the year of contract completion.

The disadvantage, on the other hand, is that it tends to bunch income, especially where a taxpayer performs work on only a few contracts at a time.

The 1986 and 1987 tax acts severely limited, but did not prohibit, the use of the completed contract method. The two acts basically left the eligibility requirements of the method intact. In a recent case of first impression, Sierracin v. Commissioner, (2) the Tax Court restricted the method's use by its interpretation of two of the eligibility requirements: (1) that the manufactured or constructed item be "unique" and (2) that the contract be subject to a risk that makes the costs and benefits impossible to determine with a high degree of certainty. This article reviews the eligibility requirements of the completed contract method in light of the changes enacted by the two tax acts and the Sierracin decision. It then discusses the extent to which the benefits from the completed contract method still are realizable.

THE EFFECT OF THE 1986 AND

1987 TAX ACTS

Before the Tax Reform Act of 1986, contractors generally were free to select one of the long-term contract methods (percentage of completion or completed contract) or any other method (cash or accrual) that would clearly reflect income. The use of the method, however, was restricted. For example, section 446(a) required that the taxpayer's method of accounting for tax purposes be based upon its method of accounting for bookkeeping purposes. This requirement, interpreted liberally by both the courts and the Internal Revenue Service, required that the taxpayer maintain adequate books and records and reconcile any differences between book and taxable income.

Through the addition of section 460, the 1986 Act limited the contractor's freedom in selecting an accounting method by requiring a new hybrid method for all long-term contracts other than certain small real estate projects. Under this new method (termed the "percentage of completion-capitalized cost" method), 40 percent of income from long-term contracts had to be reported on the percentage of completion method, with the remaining 60 percent on the taxpayer's normal method of accounting. Thus, 60 percent of income still could be accounted for under the completed contract method, assuming this was the contractor's normal accounting method.

Certain contracts for construction or improvement of real property also were still eligible to use the completed contract method under the 1986 Act. The two primary requirements for such contracts were that they were (1) estimated to be completed within two years from the commencement date of the contract and (2) performed by a contractor with average annual gross receipts not in excess of $10 million for the three years preceding the taxable year the contract was executed. (3)

For long-termcontracts governed by new section 460, costs were to be allocated in accordance with the statutory and regulatory provisions applicable to extended period long-term contracts. (4) Allocation, however, was not required for independent research and development expenses, expenses for unsuccessful bids and proposals, and costs of marketing, selling, and advertising. (5) In addition, the contractor had to capitalize any costs which it identified as attributable to the contract, pursuant to a cost-plus contract or a contract for which costs were certified under federal statute of regulations. (6)

The Revenue Act of 1987 amended the percentages established by the 1986 Act for the percentage of completion-capitalized cost method. Under the 1987 Act, 70 percent of income from long-term contracts must be reported on the percentage of compaletion method, with the remaining 30 percent of the taxpayer's normal method of accounting. (7) The new percentages apply to contracts entered into after October 13, 1987. (8)

The 1986 and 1987 legislation obviously restricted the applicability of the completed contract method. The new laws, however, did not change the definition of a long-term contract. In fact, the Conference Committee Report on the 1987 Act expressly states:

It is anticipated that the criteria and methods used by the taxpayer, including those criteria and methods used to determine if an item is "unique," prior to February 28, 1986 [the effective date of the 1986 Act changes] in determining if a particular contract was a long-term contract will continue to be used by the taxpayer. (9)

Thus, statutory, regulatory, and case law governing the completed contract method still has relevance for (1) all contracts enterd into befor February 28, 1986, (2) 60 percent of ocntracts entered into from February 28, 1986, through October 13, 1987, (3) 30 percent of contracts entered into after October 13, 1987, and (4) all real property contracts meeting the requirements of section 460(e). For these contracts, the criteria for using the completed contract method (including those addressed by the Tax Court in Sierracin must be understood before the benefits of the method can be realized.

CRITERIA FOR COMPLETED

CONTRACT METHOD

ONly "long-term" contracts may be accounted for under the completed contract method. For this purpose, a manufacturing contract is long-term only if it involves the manufacture of (1) unique items of a type not normally carried in the finished goods inventoryt of the taxpayer or (2) items normally requiring more than 12 calendar months to complete, regardless of the duration of the actual contract. (10) In addition to these requirements, the courts have required that the contract be subject to unpredictable risks--that is, an inability to determine ultimate gain or loss until completion. (11) As previously noted, the uniqueness of the item manufactured and the unpredictability of the risks involved were two key issues addressed in Sierracin.

The completed contract method also applies to building, installation, or construction contracts. In Revenue Ruling 70-67, (12) the IRS explained its rationale for allowing the completed contract method on these contracts:

One of the reasons why permission on a completed contract basis is given in the case of building, installation and construction contracts, is the fact that there are changes in the price of articles to be used, losses and increased costs due to strikes, weather, etc., penalties for delay and unexpected difficulties in laying foundations which make it impossible for any construction contractor, no matter how carefully he may estimate, to tell with any certainty whether he has derived a gain or sustained a loss until a particular contract is completed.

The courts have prohibited taxpayers from using a long-term contract method with respect to contracts for the sale of property for delivery more than one year after the signing of the contract, (13) contracts calling for the sale of lumber, (14) oil brokerage contracts requiring delivery more than one year in the future, (15) and contracts for breeding animals where a refund must be made if a live birth does not occur. (16) Thus, it is clear that long-term contract reporting is not available for general merchandising contracts that do not call for building, installation, or construction. (17)

A corporation using the completed contract method must compute earnings and profits on the basis of the percentage of completion method--that is, recognize income each year according to the percentage of the contract completed during the year. (18) Since taxable dividends are determined on the basis of earnings and profits, this requirement diminishes the possibility of a company distributing progress payments to the shareholders tax-free or making capital gain distributions under section 301(c)(2) or (c)(3).

In applying the completed contract method, neither the contract price nor the costs are includable in the taxpayer's income tax return until the contract is "finally completed and accepted." (19) The decision of when this occurs has long been a source of considerable litigation and controversy.

The long-term contract regulations specifically provide that to clearly reflect income, it may be necessary to treat either (1) one contract as several contracts or (2) several contracts as one contract. (20) Although there is general agreement with the necessity of this provision, considerable criticism has been directed toward the regulatory rules governing the severance and aggregation of contracts.

MEANING OF "FINALLY

COMPLETED AND ACCEPTED"

Under prior regulations, the courts differed significantly in their interpretations of the phrase "finally completed and accepted." The Tax Court held that income was to be reported fo rthe taxable year in which the contract was substantially completed, even though some work remained to be done. (21) In contrast, several other courts held that the regulations were to be read literally: no income was to be reported until final completion and acceptance occurred. (22)

Regulations proposed in 1971 sought to require taxpayers to follow the Tax Court's approach of recognizing income based upon substantial completion. (23) Under these proposed regulations, a contract was considered complete when (1) the remaining costs required to finish the contract entirely were insignificant compared to the amounts already expended, (2) no substantial dispute existed about the acceptability of the work performed on the portion finished, and (3) the contract had been completed in all respects essential for the basic utility of the subject matter of the contract. (24)

These conditions caused substantial adverse taxpayer comment. As a result, the proposed regulations were withdrawn and the "final completion and acceptance" standard was restored. A provision stating that "[a] taxpayer may not delay the completion of a contract for the principal purpose of deferring federal income tax," however, was added to the regulations. (25)

In 1982, both the Treasury Department and Congress still believed that completion of contracts was being deferred because of contractual obligations merely incidental to the performance of the major subject matter of the contract. (26) Consequently, the Tax Equity and Fiscal Responsibility Act of 1983 (TEFRA) required that the Secretary of the Treasury modify the regulations dealing with accounting for long-term contracts to "clarify the time at which a contract is to be considered completed." (27) These regulations were issued in proposed form in 1983.

Example One of the proposed regulations involves a contract for industrial machinery which provides that the machinery will not be accepted unless it meets certain environmental tests. If those tests are not completed until the year following the machinery's installation, the contract will not be considered finally completed and accepted until after the testing--that is, when the purchaser accepts the machinery. (28) Example Two of the proposed regulations, on the other hand, involves a contract completed in every respect necessary for the use for which the subject matter was intended, no substantial dispute between the contracting parties, and a purchaser who has notified the taxpayer of certain minor deficiencies which the taxpayer has agreed to correct at no additional charge. The additional work in this situation will not delay the time at which the contract is considered completed "because the parties have dealt with each other in a manner that indicates that the subject matter of the contract has been finally completed and accepted." (29)

Contracts with more than one subject matter. The 1983 proposed regulations would also add new rules for contracts with more than one subject matter. (30) If a contract is to be treated as a simple long-term contract for the building, installation, construction, or manufacture of (1) one or more units that represent the contract's primary subject matter, and (2) for other items (e.g., training manuals or spare parts) that do not represent the contract's primary subject matter, "final completion and acceptance" is determined without regard to the contractor's obligation to supply the items not representing the primary subject matter of the contract. (31) Nevertheless, the costs properly allocable to such other items and incurred before the end of the year in which final completion and acceptance occurs, as well as a portion of the gross contract price reasonably allocable to these other items, are to be separated from the long-term contract items and accounted for under a proper method of accounting other than a long-term contract method or the cash method. (32)

Effect of contingent compensation and other obligations. If a contract calls for additional compensation contingent upon the continued successful performnce of the contract after the subject matter has been accepted by the purchaser, the proposed regulations would provide that final completion and acceptance should be determined without regard to such terms and that the contingent compensation should be accounted for under a proper method of accounting other than a long-term contract method. (33) The proposed regulations include as an example of such contingent compensation a contract term providing that an incentive bonus will be paid if a satellite remains in operation for 20 months after it is placed in orbit. (34)

Final completion and acceptance also should be determined without regard to an obligation on the part of the contractor to assist or to supervise installation or assembly by the purchaser of the subject matter of the contract, as long as under applicable contract law, the subject matter may be accepted prior to such installation or assembly. (35) The portion of the gross contract price reasonably allocable to this obligation, as well as all costs properly allocable to the contract but not incurred prior to the end of the taxable year in which the contract is completed, should be accounted for under a proper method of accounting. (36)

Work of subcontractor. The proposed regulations would maintain the prior regulations' rule dealing with subcontractors. If the work of a subcontractor is completed prior to the completion of the entire contract by the prime or general contractor, final completion with respect to the subcontractor occurs when its work is completed and has been accepted by the party with whom it has contracted--that is, normally the prime or general contractor. (37) This rule obviously requires careful planning by subcontractors if they will not be paid until the entire contract is completed by the prime or general contractor. To avoid undesired tax consequences, the subcontractor should insist on contract terms providing that final acceptance of its work by the prime or general contractor will not occur prior to acceptance of the entire contract by the customer. Absent such a provision, the subcontractor's not being paid by the prime or general contractor until it completes the entire contract will not delay completion for the subcontractor. (38)

Effect of disputes. Under the proposed regulations, completion of a long-term contract would have to be determined without regard to whether a dispute exists at the time the taxpayer tenders the subject matter of the contract to the party with whom the taxpayer has contracted. (39) Thus, it is possible in this situation that income will be accrued prior to acceptance of the contract work by the customer.

Effect of Payment. Following existing regulations, (40) the courts generally have held that the recognition of income may not be deferred beyond the completion date merely because retainages exist on the completion date. For example, in Hudson Engineering Co. v. Commissioner, (41) the Tax Court held that a completed contract taxpayer with its underlying accounts on the cash basis had to include the gross contract price in gross income in the taxable year of completion, even though payment was not received until a later year. An item need not be included in income, however, to the extent there is reasonable uncertainty about its ultimate payment. (42) Thus, where a contractor receives obligations from a debtor and there is reasonable uncertainty that the notes will be paid, the contractor may include in income in the year of completion the fair market value--rather than the face value--of the debtor's obligations. (43)

Effect of Continuing Obligations. The Courts consistently have held that the existence of continued obligations after the completion of a contract will not justify postponing the recognition of income on the contract. For example, maintenance provisions, (44) requirements relating to a subsequent audit, (45) and guarantee provisions (46) have not prevented the recognition of income upon the completion of a long-term contract.

Effect of Contract Amendments and Termination. If a partially completed long-term contract is amended by agreement of the parties to change the scope of the work under the contract, income is reported in the taxable year of completion and acceptance of the amended contract. (47) In contrast, if a contract is cancelled, all income undisputably owed on the contract must be included in a contractor's gross income in the taxable year cancelled; this is the case even if a new contract may be executed. (48) For example, in Fort Pitt Bridge Works v. Commissioner, (49) a contract for 21 hangars was cancelled and later replaced with a new contract for 16 redesigned hangars. The original and the substituted contracts were considered two separate contracts. On the other hand, a contract for the fabrication and erection of structural steel for a power station was amended to change the fabrication and grillage of other steel, and the court considered it a single amended contract.

SEVERING AND AGGREGATING

CONTRACTS

As previously noted, the long-term contract regulations specifically provide that to clearly reflect income, it may be necessary to sever or aggregate contracts. (50) In enacting TEFRA, however, Congress evinced its belief that these regulations were not achieving the desired result of clearly reflecting income. The legislative history of the TEFRA provisions reflects a congressional belief that income was being inappropriately deferred by treating certain agreements as single contracts for several units rather than several contracts for single units, even though each unit was delivered or accepted separately and was independently priced. (51) In TEFRA, congress instructed the Treasury to modify its regulations to clarify when one agreement should be treated as more than one contract and when two or more agreements should be treated as a single contract. (52)

Severing Contracts. Both the existing and the proposed long-term contract regulations provide that one contract generally will not be severed into separate contracts unless (1) the contract provides for separate deliveries or acceptances of portions of the subject matter of the contract or (2) there is no business purpose for entering into one contract rather than several. (53) Both sets of regulations state that the mere fact that a contract calls for separate deliveries or acceptances of portions of the subject matter of a contract does not necessarily require that the contract be severed. (54)

The proposed regulations would add, for taxable years ending after December 31, 1982, that the following factor may constitute evidence of there being no business purpose for entering into one agreement rather than several: whether the agreement covers two or more subject matters, and whether it is readily apparent that one of the subject matters is the agreement's principal subject matter. (55) The proposed regulations would also provide that if an agreement is modified to increase the number of items to be supplied under the agreement--for example, by the exercise of an option or the issuance of a "change order" --the additional items generally should be treated as a separate contract or as several separate contracts and should be treated as entered into on the date the contract modification becomes effective. (56) The examples below are included in both sets of regulations to illustrate the severance provisions. (57)

Example 1. P, a calendar-year taxpayer engaged in the construction business and using a long-term contract method, enters into one contract in 1982 with A, a real estate developer, to build three houses of different designs in three suburbs of a large city. The houses are to be completed, accepted, and put into service in 1983, 1984, and 1985. The portion of the total contract price attributable to each house can reasonably be determined. The contract should be severed and treated as it the contract to build each house were a separte contract for purposes of applying the long-term contract method.

Example 2. Z, a calendar-year engaged in the construction business and using a long-term contract method, enters into contract to build an office building for the T Bank in 1981. In first three floors of the bank buildingare completed and T occupies these floors and uses them to conduct its banking business. The remaining seven floors are not completed and accepted until 1983. Under the circumstances, it is clear that even though separate acceptance of portions of the subject matter occurred, the subject matter of the contract was essentially a single unit (a building), and there was a business purpose for entering into one contract rather than several. Consequently, the contract will not ordinarily be severed.

Aggregating Contracts. Both the existing and the proposed long-term contract regulations contain aggregation provisions comparable to those for severance--that is, they provide that several separate contracts generally will not be aggregated unless (1) the separate contracts would be treated as one contract under customary commercial practice in the contractor's trade or business or (2) there is no business purpose for entering into several agreements rather than one. (58) Both sets of regulations also provide guidance on when two contracts entered into between the same parties should be aggregated (without regard to the order in whihc the contracts were entered into or performed and without regard to whether one of the contracts could actually be performed without the prior or contemporaneous performance of the other). Specifically, the regulations provide that aggregation may be appropriate where a reasonable business person would not have entered into one of the contracts but for the terms of the other contract (or more favorable terms). (59) That one of the contracts would not have been entered into but for the "expectation" that the parties would enter into the otehr contract, however, is not considered conclusive evidence that the two contracts should be aggregated. (60) The regulations include the examples below to illustrate the aggregation principles: (61)

Example 1. X, a calendar-year shipbuilder using a long-term contract method, enters into two contracts with M at about the same time in 1982. These contracts are the product of a single negotiation. Under each contract, the taxpayer is to construct for M a submarine of the same class. Although the specifications for each submarine are similar, it is anticipated that, since the taxpayer has never constructed this class of submarine before, the costs incurred in constructing the first submarine (to be delivered in 1983) will be substantially greateer than the costs incurred in constructing the submarine (to be delivered in 1984). If the contracts are treated as separate contracts, it is estimated that the first contract would result in little or no gain while the second contract will result in substantial profits. A reasonable business person would not have entered into the contract to construct the first submarine for the price specified without entering into the contract to construct the second. The two contracts must be treated as one for purposes of applying X's long-term contract method.

Example 2. T, a calendar-year taxpayer engaged in the business of manufacturing aircraft and related equipment, contracts in 1982 with the B government to manufacture ten military aircraft for delivery in 1984. It is anticipated at the time the contract is entered into that B may contract with T for the production and sale of as many as 300 of these aircraft over the next 20 years. In negotiating the price for the contract, B and T take into account the expected total cost of manufacturing the ten aircraft, the risks and the opportunities associated with contract, and all other factors that the parties consider relevant, in such a manner that T would have entered into the contract for the terms agreed upon regardles of whether T would actually enter into one or more additional production contracts. It is unlikely, however, that T would have entered into the contract but for the expection that T and B would enter into additional production contracts. In 1984, the ten aircraft are completed by T and accepted by B. In 1984, T also enters into a contract with B to manufacture 20 aircraft of the same type for delivery in 1986. In negotiating the price for these 20 aircraft, B and T take into account the fact that the expected unit costs for this production run of 20 will be different than the unit costs of the ten aircraft completed in 1984, but also that the expected unit costs of the production run of 20 will be substantially higher than the costs of future prodcution runs. Because the pride awarded for each of the two contracts takes into account the expected total costs and the risks expected for each contract standing alone, the terms agreed upon for any one of the contracts are independent of the terms agreed upon for the other contracts. Under the facts of this example, the two contracts may not be aggregated.

Affirmative Use of the Severance and Aggregation Provisions. The existing regulations clearly state, and the proposed regulations imply, that only the Commissioner (and not the taxpayer) may take action under the severance and aggregation rules. (62) This provision, however, runs counter to the Eighth Circuit's decision in Helvering v. National Contracting Co. (63) There, the taxpayer was permitted to aggregate eight separate contracts entered into under one set of general conditions to build schools.

SIERRACIN: UNIQUENESS,

RISK UNPREDICTABILITY, AND

SEVERANCE

As previously noted, the completed contract method is appropriate for a manufacture contract only if it involves the manufacture of a unique item of a type not normally carried in the taxpayer's finished goods inventory or an item normally requiring more than 12 calendar months to complete. (64) An additional criterion for use of the completed contract method applicable to all long-term contracts is that the contract be subject to umpredictable risks. Both the uniqueness of the items manufactured and the existence of umpredictable risks were at issue in Sierracin v. Commissioner. (65) The IRS also argued that even if the completed contract method were apppropriate, certain of the contracts had to be severed by delivery in order to clearly reflect income.

Company Organization and Products. From 1976 through 1980, Sierracin Corporation used the completed contrct method of accounting for three of its five divisions. The Sylmar division manufactured aircraft transparencies (i.e., windshields, canopies, and windows); the Transtech division produced security windows for buildings and vehicles; and the Magnedyne division produced DC-torque motors and tachometers. None of the three divisions maintained an inventory of products; instead, each product was manufactured for a specific customer under a contract with the customer.

"Unique" Items. Sierracin claimed that its products were unique items within the meaning of the regulation, and the IRS claimed thet they were not unique items. Relying on Webster's Dictionary, Sierracin asserted that the best meaning for the word was "unusual" or "notable." The IRS, on the other hand, relied on the Oxford English Dictionary to define the term unique as "being the only one; sole."

The Tax Court held that both sides had gone astray. Sierracin's proposed definition was too broad and subjective, whereas the IRS's was too narrow and restrictive. Under Sierracin's definition, the completed contract method could be used to account for most multi-unit manufacturing contracts. In fact, products like the pet rock, the hula hoop, and the Frisbee could be described as "unusual" or "notable." The IRS's definition, on the other hand, would bar use of the method to account for any multi-unit contract, and the Tax Court found numerous cases suggesting that this approach was incorrect. (66) Accordingly, the Tax Court rejected both definitions and focused instead on the meaning of the regulation and the facts and circumstances of Sierracin in light of the justification for the completed contract method of accounting.

Looking at Treas. Reg. Sec. 1.451-3(b)(1)(ii), the court found that the term unique could be used to describe items designed for the use of a particular customer--for example, in the regulation, custom-designed machinery was considered unique but folding chairs were not. This approach to the word "unique" was found by the court to be consistent with the cases--that is, in several cases where the manufactured items were designed for the needs of a specific customer, the tax payers were allowed to use the completed contract method. By the same token, the method was denied in a case where the manufactured items were not shown to be designed for the specific needs of a specific customer. Thus, the court held that the degree of custom-design was of special importance in determining whether the items were unique.

Applying this meaning to Sierracin, the court held that the items produced by all three divisions were unique. Explaining its holding, the court stated:

The items produced by Sylmar, Transtech, and Magnedyne are custom designed. The products of each division satisfied the highly specialized needs of specific customers. Each transparency produced by Sylmar is limited in use to a specific opening in a particular model of aircraft. Each glazing produced by Transtech can only be installed in a specific opening in a specific building. Many of the machines produced by Magnedyne are "one of a kind." These products are not suitable for functions or customers other than those for which they were designed. (67)

Unpredictable Risks. Sierracin also argued that the proper use of the completed contract method of accounting hinged upon the existence of a risk creating sufficient incertainty to make it difficult to predict the outcome of the contract on an interim basis. The IRS agreed that risk was clearly a factor; however, it argued that risk was relevant only to the extent it affected the taxpayer's ability to reliably estimate revenues. The tru test of eligibility, according to the IRS, was the degree to which the manufacturing process was "like construction." From Peninsula Steel Products & Equipment v. Commissioner, (68) the IRS derived five factors to limit the use of the long-term contract methods to those manufacturing contracts that share the characteristics of construction-type contracts:

1. The subjects of the contracts were "large items taking a relatively long time to complete."

2. Conformity to specifications was determined only after shipments

3. Additional work could be required after shipment

4. Advance payments

5. The difficulty of estimating costs of performance until after acceptance.

The tax Court found that the parties disagreed over the amount of risk--unpredictability--required for the completed contract method rather than the risk element itself. The court also concluded that Peninsula Steel didnot support the IRS's "like construction" test, because each of the factors used in that case was but one facet of the single concept of unpredictability. In other words, each factor had to bear some rational relationship to the two purposes of completed contract accounting: (1) alleviating the bunching of income faced by taxpayers engaged in long-term contracts and (2) accounting for contracts where ultimate gain or loss cannot be accurately determined until completion of the contract. Moreover, stating that ultimate gain or loss could not be accurately determined until the contract was completed was only another way of stating that the contract was subject to unpredictable risks. Thus, the other major eligibility factor decided by the Tax Court in Sierracin was the degree of unpredictability to which Sierracin's contracts were subject.

On this issue, the Tax Court found that only two of the three divisions--Sylmar and Transtech--were subject to unpredictable risks; Magnedyne was not. Explaining its holding, the court stated:

The contracts of Sylmar and Transtech are . . . subject to unpredictable risks that make it difficult to account for ultimate profit or loss on an interim basis. Sylmar's manufacturing process is disrupted at unpredictable intervals by (1) difficulty in obtaining quality raw materials, (2) unforeseen chemical reactions of the finished materials that comprise Sylmar's transparencies, (3) difficulty in moving from the development phase to the production phase, and (4) post-development design changes. Transtech's manufacturing process is disrupted at unpredictable intervals by (1) difficulty in obtaining quality urethane and other materials, (2) the nonautomated nature of Transtech's production process, and (3) Transtech's dependence on the accuracy of the glazing contractor's estimate, or "take-off."

Taxpayer has not shown that Magnedyne's manufacturing process is subject to similar risk. . . . Many of the design variants produced by Magnedyne were only nominally "unique"; Magnedyne manufactured units sharing a basic design for many customers over a period of many years. . . . Nothing in the record suggests that Magnedyne's attempts to estimate overall contract costs were unsuccessful or even particularly difficult.(69)

Thus, the court ruled that even though Magnedyne's products met the custom-designed meaning of unique, they were not eligible for the completed contract method because of the unpredictability factor. Only the Sylmar and Transtech divisions met both the uniqueness and risk unpredictability requirements.

Severance. As an alternative, the IRS argued that the taxpayer's use of completed contract accounting should have been limited by requiring the reporting of gain or loss as each unit or combination of units was delivered by the Sylmar or Transtech divisions. Sierracin countered that its contracts could not be severed by delivery because it treated work orders as contractual units for valid business reasons. The IRS conceded this point, but still argued that the taxpayer's contracts had to be severed by delivery in order to clearly reflect income.

Since the regulations provided the Commissioner much latitude in interpreting the severance and aggregation provisions, the Tax Court said that the only way the determination could be overcome was to establish that the IRS was "plainly arbitrary" in severing Sierracin's contracts by delivery. To decide this point, the court looked to Treas. Reg. Sec. 1.451-3(e) and Prop. Reg. Sec. 1.451-3(e). No case reported since adoption of the regulation in 1976 had dealt with the severance of a contract accounted for under the completed contract method. The language in the regulations, however, suggested that whether an agreement should be severed depended on all the facts and circumstances. In the court's view, the most important fact and circumstance to be considered on this issue was independent pricing, as shown in Example Two of the regulations and Examples Two and Six of the proposed regulations.

Relative to Sierracin, the Tax Court found that the circumstances surrounding the Sylmar and Transtech contracts were similar to the facts of the examples in the regulations. Because many of Sylmar's products involved novel technology that changed over the lifetime of a program, the price of each transparency was based on the total quantity called for in a program, not the quantity shipped to the customer in any specific delivery. Sylmar's delivery schedules were arranged to accommodate its customers' production rates for aircraft. If prices were determined on a per shipment basis, they would have been substantially higher. Transtech's deliveries also were not independently priced. As a practical matter, Transtech could not have calculated with any certainty the total costs and, hence, the total profit associated with any job prior to the completion of that job. Because the Sylmar and Transtech contracts could not be independently priced by delivery, and in consideration of all the other facts and circumstances, the Tax Court held that these contracts could not be severed.

Summary and Conclusion

The Tax Reform Act of 1986 and Revenue Act of 1987 dealt a serious, but not fatal, blow to the use of the completed contract method. For contracts entered into after October 13, 1987, only 30 percent may be accounted for under the completed contract method. The two acts, however, did not change the eligibility requirements of the method. Thus, all case law governed by previous statutes continues to be relevant.

In the recent decision of Sierracin, the Tax Court looked at one eligibility requirement, the uniqueness of the items manufactured, for the first time and interpreted a second requirement, unpredictable risk. The court rejected two dictionary definitions of the term unique in favor of the "custom-made" meaning found in both the regulations and the facts and circumtances of the case. On the unpredictable risk issue, the court concluded that the inability to predict revenues and expenses was tantamount to "unpredictable risk" and was a prerequisite to using the completed contract method.

The court also addressed the issue of severance. The IRS had argued that even if the eligibility requirements were met, severance required the reporting of gain or loss as each unit or combination of units was delivered under contract. The Tax Court, however, rejected the IRS argument because the deliviries were not--and could not have been--independently priced.

The upshot of both the recent legislation and Sierracin is that the completed contract method is not an appropriate means of clearly reflecting all income. It is appropriate if certain conditions exist, however, and the taxpayer must be fully attuned to these conditions to realized the benefits of deferring income until work under a contract is finally completed and accepted.

Editor's note: As this issue of The Tax Executive goes to press, Congress passed the Technical Corrections and Miscellaneous Revenue Act of 1988 (H.R. 4333). the final legislation increased from 70 to 90 percent the portion of income from long-term contracts that must be reported on the percentage-of-completion method; the remaining 10 percent may be reported using the taxpayer's normal method of accounting

Footnotes -- Recent Development Concerning the Completed

Contract Method of Accounting

(1) Treas. Reg. Sec. 1.451-3(d)(1).

(2) 90 TC No. 27 (1988).

(3) I.R.C. [section] 460(e).

(4) I.R.C. [section] 460(c)(1).

(5) I.R.C. [section] 460(c)(4).

(6) I.R.C. [section] 460(c)(2).

(7) I.R.C. [section] 460(a)(1), as amended by Revenue Act of 1987, [section] 10203(a)(1)-(2).

(8) 1987 Act, [secton] 10203(b)..

(9) 1987 Act, [section] 10203.

(10) Treas. Reg. Sec. 1.451-3(b)(1)(ii).

(11) Sierracin v. Commissioner, 90 T.C. No. 27(1988); Reco Industries, Inc. v. Commissioner, 83 t.C. 912 (1984); Peninsula Stell Products & Equip. Co. v. Commissioner, 78 T.C. 1029 (1982); Fort Pitt Bridge Works v. Commissioner, 24 B.T.A. 646 (1931), aff'd on this issue, 92 F.2d 825 (3rd Cir. 1987).

(12) 1970-1 C.B. 117.

(13) Wood v. Commissioner, T.C. Memo 1955-301, aff'd on this issue, 245 F.2d 888 (5th Cir. 1957).

(14) C.H. Swift & Sons v. Commissioner, 13 B.T.A. 138 (1928); Deer Island Logging Co. v. Commissioner, 14 B.T.A. 1027 (1929).

(15) Lakeside Petroleum Co. v. United States, 1 F.Supp 31 (E.D. III. 1932).

(16) Estate of B.F. Whitaker v. Commissioner, 27 T.C. 339 (1956), aff'd 259 F.2d 379 (5th Cir. 1958).

(17) See e.g., J.J. Little & Ives Co. v. Commissioner, T.C. Memo 1966-68.

(18) I.R.C. [section] 312(n)(6).

(19) Treas. Reg. Sec. 1.451-3(b)(2) and (d)(1).

(20) Treas. Reg. Sec. 1.451-3(e)(1).

(21) Bien v. Commissioner, 20 T.C. 49 (1953); acq. 1953-2 C.B. 3; Ehret-Day v. Commissioner, 2 T.C. 25 (1943); Turner v. Commissioner, T.C. Memo 1958-181; Wohlfeld v. Commissioner, T.C. Memo 1958-128.

(22) Thompson-King-Tate v. United States, 296 F.2d 290 (6th Cir. 1961); E. E. Black v. Alsup, 211 F.2d 879 (9th Cir. 1954); Rice, Barton & Fales, Inc v. Commissioner, 41 F.2d 339 (1st Cir. 1930); King v. United States, 220 F. Supp. 350 (E D. Tex. 1963).

(23) Prop. Reg. Sec. 1.451-3(b)(2).

(24) Id.

(25) Treas. Reg. Sec. 1.451-3(b)(2).

(26) S. Rep. No. 97-494, 97th Cong., 2d Sess. 200 (1982.)

(27) Pub. L. No. 97-248, [section] 229.

(28) Prop. Reg. Sec. 1.451-3(b)(2).

(29) Prop. Reg. Sec. 1.451-3(b)(2)(i)(B), Example (2). See Example (3) for another application of the same standard.

(30) Prop. Reg. Sec. 1.451-3(b)(2)(ii)(A).

(31) Id.

(32) Id.

(33) Prop. Reg. Sec. 1.451-3(b)(2)(iii).

(34) Id.

(35) Prop. Reg. Sec. 1.451-3(b)(2)(iv).

(36) Id.

(37) Prop. Reg. Sec. 1.451-3(b)(2)(v); Hooper Construction Co. v. Renegotiation Board, 35 T.C. 837 (1961).

(38) See e.g., Helvering v. National Contracting Co., 69 F.2d 252 (8th Cir. 1934), where a subcontractor who had completed work on its individual contract was permitted to delay the recognition of income under its contract until the completion of the entire building because of the restrictions placed on the subcontractor until the entire building was completed.

(39) Prop. Reg. Sec. 1.451-3(b)(2)(vi).

(40) Treas. Reg. Sec. 1.451-3(d)(1).

(41) 11 T.C. 1042 (1948), aff'd, 183 F.2d 180 (5th Cir. 1950).

(42) Id.

(43) Id.

(44) Helvering v. National Contracting Co., 69 F.2d 252 (8th Cir. 1934); Vang Receivers v. Lewellyn, 35 F.2d 283 (3d Cir. 1929).

(45) Mesta Machine Co. v. Commissioner, 12 B.T.A. 523 (1928), acq. VIII-1 C.B. 30 (1928).

(46) W. J. Scholl Co. v. Commissioner, 30 B.T.A. 993 (1934); Cronin Co. v. Lewellyn, 9 F.2d 974 (W.D. Pa. 1925).

(47) The Fort Pitt Bridge Works v. Commissioner, 92 F.2d 825 (3d Cir. 1937).

(48) The Fort Pitt Bridge Works v. Commissioner, 92 F.2d 825 (3d Cir. 1937); Hudson Engineering v. Commissioner, 11 T.C. 1042 (1948), aff'd, 183 F.2d 180 (5th Cir. 1950).

(49) 92 F.2d 825 (3d Cir. 1937).

(50) Treas. Reg. Sec. 1.451-3(e)(1).

(51) S. Rep. No. 97-494, 97th Cong., 2d Sess. 200 (1982).

(52) Id.

(53) Treas. Reg. Sec. 1.451-3(e)(1); Prop. Reg. Sec. 1.451-3(e)(1).

(54) Id.

(55) Prop. Reg. Sec. 1.451-3(e)(1).

(56) Id.

(57) Treas. Reg. Sec. 1.451-3(e)(2) and Prop. Reg. Sec. 1.451-3(e)(2), Examples (1) and (4).

(58) Treas. Reg. Sec. 1.451-3(e)(1); Prop. Reg. sec. 1.451-3(e)(1).

(59) Id.

(60) Id.

(61) Treas. Reg. Sec. 1.451-3(e)(2), Examples (2) and (6); Prop Reg. Sec. 1.451-3(e)(2), Examples (2) and (5).

(62) Treas. Reg. Sec. 1.451-3(e)(1)(c); Prop. Reg. Sec. 1.451-3(e)(1).

(63) 69 F.2d 252 (8th Cir. 1934).

(64) Treas. Reg. Sec. 1.451-3(b)(1)(ii).

(65) Sierracin Corp. v. Commissioner, 90 t.C. No. 27 (1988).

(66) See e.g., Spang Industries, Inc. v. United States, 791 F.2d 906 (Fed Cir. 1986); Stephens Marine, Inc. v. Commissioner, 430 F.2d 679 (9th Cir. 1970); Reco industries, Inc. v. Commissioner, 83 T.C. 912 (1984); Peninsula Steel Products & Equip. Co. v. Commissioner, 78 T.C. 1029 (1982); Treas. Reg. Sec. 1.451-3(b)(2)(ii) (B).

(67) Sierracin Corp. v. Commissioner, 90 T.C. No. 27, at 186 (1988).

(68) Peninsula Steel Products & Equip. Co. v. Commissioner, 78 T.C. 1029 (1982).

(69) Sierracin Co. v. Commissioner, 90 T.C. No. 27, at 186 (1988).